Shares hit as banking crisis bites in Europe

* MSCI world equity index down 1.9 pct at 305.48

* B&B, Fortis bailouts shove European shares, euro lower

* TARP overshadowed as investors fret on banking contagion

By Veronica Brown

LONDON, Sept 29 (Reuters) - European shares fell heavily on Monday as fallout from the credit crisis hit the region's banking sector, forcing partial nationalisation of two banks and leaving investors to ponder the impact of a U.S. bailout plan.

The euro and sterling fell in the wake of share prices sliding, while safe-haven government bond prices rose.

Money markets remained frozen with banks refusing to lend to one another for all but the shortest periods, prompting the European Central Bank to offer additional funds.

The hard-fought U.S. proposal to establish a $700 billion fund to buy illiquid securities will be sent for a Congressional vote later on Monday after days of tense negotiations and compromises.

But European worries threatened to overshadow the proposal after the Belgian, Dutch and Luxembourg governments were forced to rescue financial firm Fortis over the weekend to prevent a domino-like spread of failure.

In addition, the UK government said that lender Bradford & Bingley's branch network will be sold to Spanish bank Santander and the remainder of the group would be nationalised.
"The nationalisations have an incredibly negative read across for the sector," said Mark Sartori, head of European sales trading at Fox-Pitt, Kelton.

"The contagion is spreading to mainland Europe and everyone's asking: who's next?" he added.

By 0830 GMT, MSCI main world equity index fell 1.9 percent .MIWD00000PUS, a 1-1/2 week low. The FTSEurofirst 300 Index was down 2.7 percent at 1073.97 , while a measure of banking stocks tanked 5 percent to 267.76 .

European shares followed a lead set in Asia overnight with Japan's Nikkei share average .N225 posting a 1.3 percent decline, erasing earlier gains.

The December U.S. S&P 500 future was down 2 percent SPc1, reversing initial gains on news the plan was set for a vote in the House of Representatives.

EURO FEELS THE HEAT

Currency markets also felt the pinch of banking sector contagion, with the euro falling more 2 percent to a 10-day low of $1.4310 . A fall of 2.1 percent or more would be the biggest 1-day fall since Jan 2001, while a fall of 2.3 percent or more would be the biggest since its launch in 1999.

In addition, sterling dropped almost 2 percent to $1.8085 .

"The crisis has taken on a more international complexion with B&B and Fortis ... There is a worry whether there is the ability or the willingness within Europe for a U.S.-style response," Calyon senior currency strategist Daragh Maher said.

The dollar was well-bid elsewhere on hopes of smooth legislative passing of the $700 billion proposal, rising 1.3 percent versus the Swiss franc . The high-yielding Australian and New Zealand dollars fell 1.7 and 1.3 percent respectively.

December Bund futures FGBLZ8 were 88 ticks higher at 114.68. Two-year bond yields fell to their lowest since mid-April, while 10-year yields were just under 16 basis points lower at 4.155 percent.

Two-year swap spreads, indicating the strains in the market, rose as high as 120 basis points from 113 bps late on Friday.

In early London trade on Monday the interbank cost of borrowing dollars for three months was indicated as high as 5.27 percent , the highest this year, according to Reuters data.

The closely-watched TED spread, or the difference between these market-based dollar rates and three-month U.S. government borrowing rates, fluctuated in a wide range of around 280 to 440 basis points.

SAFETY VS RISK

Washington's bailout package, though unpopular with the public and viewed sceptically by some analysts, is the biggest effort yet by the U.S. government to ease the worst global financial crisis since the Great Depression.

Yet it alone has not been enough to reverse a powerful move by global investors to purge their portfolios of risk.

"The package will improve liquidity in the system. But I don't think lenders are going to go out carte blanche and provide new capital to the market in an aggressive way," said Leigh Gardner, head of equities distribution for ABN AMRO in Australia. (Additional reporting by Kevin Plumberg in Hong Kong, Jessica Mortimer and Joanne Frearson in London) (Editing by Stephen Nisbet)